Friday, January 28, 2011

United States: the problem is the economy

Globalization is causing the dominant world power to lose its competitive advantages, but the US government refuses to tighten its belt. This is a straight explanation of the major economic story of the decade.

A new challengeSince the fall of the Berlin Wall, the US has been enjoying its status as the world's only superpower, but as always happens in history, this is a temporary situation that is untenable in the long term.In the past, the United States' main challenge came from Communism. Today the challenge comes from a globalized economy in which it is necessary to simultaneously collaborate and compete with other market economies. This requires important changes in the vision people from the US have of themselves and their role in the world, but these changes are difficult to bring about.The US has benefited from historically exceptional economic conditions, but these conditions are being undercut by changes in the rest of the world.

The advantages of the United States

The theory of American exceptionalism has been popular in many circles, and has been justified by authors that underline the differences between European societies, with stratified institutions and Medieval roots, and the liberty and democracy of the US, which have permitted individual creativity and innovation, as well as the great industrial development of the late 19th century.

It's true that US institutions liberated the creativity of the citizens, but the United States also benefited from a set of factors that favored economic development. However, these factors have changed drastically in the last decades.

Historically the United States has been a country with a scarcity of labor as compared to other productive factors. The US is endowed with a wealth of natural resources, the population density is very low; the country was able to accumulate capital rapidly, generate great technological change, and had a good educational system. Furthermore, it has not suffered a [recent] war in its territory. Hence during the first and second World Wars, the US accumulated capital while Europe lost it.

Surely some of these factors were promoted by US institutions, but others were not.

Magnet for migrants

The privileged factors present in the US resulted in high salaries for those who were willing to work in a disciplined manner, even if they had no special skills. These salaries were not the result of people's working harder in the US, but rather of the aforementioned conditions. If you were born in Colombia and knew how to lay brick very efficiently, you were going to have a low salary, but if you were born [or went to] the US and did the same, you could live well. Because of this the country has been a magnet for attracting immigrants.

The problem, as noted above, is that the advantages of the US have been disappearing, and will continue to decrease. This is the reason why the presence of many undocumented immigrants in the country no longer seems so justified. Their argument that the US has traditionally been a country of immigrants rings hollow to many citizens, especially blacks, who must compete most directly with illegal immigrants.

A shrunken planet

The changes in the comparative advantages of the US have been enormous. The advantage of the traditional manufacturing sector has been lost, and the country has experienced a massive process of de-industrialization.

The development of communications and the decrease in transport costs have "shrunken" the world, and continue to weaken other advantages in parts of the service sector. For example, call centers have been relocated abroad. High medical costs have prompted many in the US to seek care in other countries, a trend that continues to grow.

The point is that while foreign commerce was a small fraction of the country's income and consumption, and the US was relatively self-sufficient, it was possible to maintain high salaries in unskilled jobs, but increasing globalization has totally changed the situation, and these high salaries are now found only in sectors that don't compete with imports, or that export cutting-edge products.

The majority of such jobs are in what are known by economists as noncommercial sectors or internationally non-transferable. Examples are the public sector, education, senior citizen care, and construction. Nevertheless, in these sectors the labor supply is growing, which diminishes salaries.

Inequality and discontent

The above-mentioned trends have caused income distribution in the US to be increasingly unequal. Those who have the education and the skills to participate in high-tech industries can receive a good income, but the rest of the labor force faces stagnant or diminishing salaries.

This has destroyed the myth that each generation in the US has the right to live better than their fathers, and at the same time it has undercut the belief in the consumerist lifestyle. It has often been said that it is important to distinguish necessities from consumer desires generated by the very consumer culture itself. All the above means that in the middle and long term, income and wealth distribution problems will become worse.

As mentioned, in the past whoever was willing to work hard with his hands could live well. Today in the knowledge economy there are other requirements to achieve a decent life. The goal requires an increase in labor productivity, which demands an education that develops analytical capacities, and an industrial development policy in modern sectors like protection of the environment and alternative energy.

Nevertheless, such a policy would not resolve the problems of those who have lost jobs in traditional sectors and who are unable to readapt to jobs with new skill sets.

Boom and crash of finances

During the 90s, the computer tech revolution led to economic growth, increased productivity and standards of living, but it also generated a bubble in the stock market, which collapsed in 2000.

Unlike what happened with IT in the 90s, in the 2000s there was no industry that led to productivity growth.

Changes in financial market regulation were also important. For a long time banks had lobbied for the government to relax Depression-era restrictions on certain financial activity. They successfully overturned these rules in 1995, during the Clinton administration. These changes permitted the surge of derivatives markets, and also facilitated mortgage lending. The idea was to make house ownership more accessible, for which requirements for obtaining loans were lowered. The banks could even grant loans for a value greater than the house price.

The changes in financial regulation promoted the growth of the finance sector and of housing demand. In the long term, housing prices in a city depend on its inhabitants' income. Construction absorbed lots of unskilled labor and paid good wages, and the ease of obtaining mortgages led to an increase in housing prices, but with stagnant productivity in the economy in general.

Furthermore, average salaries didn't rise, and the relationship between housing prices and salaries grew unsustainably, generating a bubble that burst starting in 2007.

The fiscal deficit

Simultaneously, president Bush got the country into a preemptive war in Iraq and a poorly-managed war in Afghanistan. In 2001 he fought for a reduction in income taxes in order to generate employment.

This reduction was programmed to expire at the end of 2010, when the maximum federal income tax rate would rise from 35 to between 36 and 39.4 percent.

During the Clinton years the federal budget arrived at a surplus of 2.37% of the GNP in 2000.

During the first year of the Bush mandate, the surplus decreased to 1.26% of the GNP, and from then on there were large deficits, between 2 and 3.5% of the GNP until 2008. In 2009 and 2010 this deficit grew exorbitantly as a result of the bailout of the finance sector, increases in unemployment payments, transfers to the state governments as part of the stimulus plan, and the growth in health and retirement costs for the aging population. The result was a deficit of 9.91% of the GNP in 2009, and 10.64% last year.

More debts instead of adjustments

During the past decade, when the country declared war on terrorism, the citizenry was not asked to save in order to finance war costs, as happened during the Second World War. Instead, the populace was encouraged to spend more.

Deregulation of the financial system made access to credit easier, and the real estate bubble made many people feel rich, which led to growth in mortgages and consumer spending.

The wars in Iraq and Afghanistan were to a certain degree painless. The number of combatants is very small, weapons are highly advanced, and the families that have lost children are very few.

Meanwhile, the great majority of people in the US increased their consumption and decreased savings to about 1% of the GNP. It was as if someone had said to the people, "your contribution to spread democracy is to spend more". It would seem that the US had misread Descartes: I spend and consume, therefore I am.

In fact, a large part of the financing for the wars has come from abroad, mainly China and Japan, which have bought US treasury bonds.

On the other hand, the US has trade deficits in its balance of payments, which have continued for a long time, and have frequently been linked to the price of imported oil. During the last ten years the commercial deficits have always exceeded 3% of the GNP, and in 2006 and 2007 they exceeded 6%.

More unemployment and more inequality

The macroeconomic house of cards fell in 2008, and since then unemployment has been very high, between 9.5 and 10%. As noted, globalization has made it very difficult to maintain high salaries in the country, a problem that has been accentuated by bad policies and low levels of education.

Income and wealth have become more concentrated since the 1970s, a trend that was aggravated in the last decade and the Great Recession, to the point that today the richest one percent of the US populace receives 20% of income.

The above scenario recalls the majority of Latin American countries during the 1980s debt crisis. The difference is that the currency of the US is the world's major reserve currency, so the country doesn't have to recur to the much-maligned IMF. Hence the US will have to make a structural adjustment, but only via the free market, which raises many questions.

Adjustment without the IMF

Traditionally, structural adjustment programs are seen as coming forcibly from a hostile, exploitative outside world. In the case of the United States, the adjustment is necessary, and the more they wait to enact it, the more painful it will be. Nevertheless, the political system is designed to try to avoid adjustment.

The sad thing is that for a long time the country indebted itself abroad, but those funds were used mainly for consumption and war, which generated no better education or infrastructure, and at the same time the majority of people in the US didn't save for old age.

The reality is that an important part of the external financing was misspent, and now it is time to start repaying. But today the United States has high unemployment, and a grave fiscal problem.

Monetary policy in this case is ineffective, because interest rates are already at very low levels and investment isn't increasing. It's a classic case of the "liquidity trap".

The jobs created during the last decade in the construction industry will not come back, because the demand for housing simply will not grow appreciably in the next years.

The financial sector has also shrunken, which means that the two leaders of the prior bonanza won't help to solve the employment problem.

The country needs to strengthen transport and energy infrastructure, develop clean energy, and protect the environment. On the other hand, the aging population will require a larger expenditure in health and care for seniors.

At the same time, the technology gap has increased between those with modern skills and those with traditional skills, so education must make a great effort to address this.

Nevertheless, the aforementioned deficits don't allow the assignation of more resources to solve these problems without raising taxes.

A past that never was

To the above we must add the rise of the Tea Party, a right-wing group that distrusts the government, wants to diminish not only government spending but also market regulation, and dreams of returning to an idealized past of a United States that never existed.

The results of the last election showed the power of this group, and it is expected that the new Congress will block the better part of the reforms that president Obama would like to propose.

In its turn, the left wing of the Democratic party is very disappointed in Obama over the concessions he has made to conservatives. In effect, many young people that voted for Obama in 2008 abstained from the 2010 election.

In Congress the debates are ever-more ideological and there is less possibility of arriving at negotiated agreements.

The expiration of the income tax cuts from the Bush era is a clear example of the challenges facing the government.

The case of the tax reduction

Democrats proposed maintaining the lower tax rates for people whose incomes were below one million dollars, but this was unacceptable for the Republicans, who thus created a dilemma for the President: if he didn't agree to extend the Bush tax cuts to all payers, income tax would increase for everyone on the first of January, and since the Republicans would have the majority in the House starting then, they would make any more progressive option very difficult.

The Republican argument is that those who have high incomes deserve this money, and are the ones that invest and generate jobs. The problem is that in an open, globalized economy, many of them will invest in China and other emerging economies, and not in the US. In effect, during the low-tax Bush years, employment rose much less than in the prior decade, when capital gains taxes were much higher.

In the end, Obama accepted an extension of the tax cuts for two years, in the hope of using the issue of taxes on the rich in the 2012 political campaign, when he will run for reelection.

Today the government economists' line is that it's a bad idea to raise taxes in the middle of a slow, weak recovery from the Great Recession.

Of course, for many politicians it's never a good time to raise taxes, and they will always look to avoid structural adjustments.

A mob of lenders?

To compete in a globalized world, the United States must decrease military spending and end its two costly, useless wars, which waste a lot of resources. People in the US must increase savings and decrease consumption, in order to pay the foreign debt. The society has to control health costs, which now stand at 17% of GNP. And the country must improve its basic education.

On top of this, the country must decrease its dependence on foreign oil, improve infrastructure, and reverse the tendency of concentration of wealth and income.

These are structural problems that, if left unsolved, will weaken the country on the international stage, and generate huge internal tensions. Nevertheless, the solution to these structural problems can be put off as long as there are buyers for US Treasury Bills.

Since the IMF can't demand changes, these demands must come from those who have the bonds, because it is they who will lose if there is a panic in which no one buys US bonds and the dollar depreciates seriously.

China and Japan are the major holders of US debt (aside from the Federal Reserve system). Retirement funds in the US are another important holder of bonds.

History has few examples of dominant countries that indebt themselves too much and end up bankrupt. Some would offer the example of Spain in the 16th and 17th centuries. This might be a good example, as it illustrates how the adjustment process is slow, but in the end the country loses power and enters a grave crisis.

All the same, it is likely that in a globalized world, where there are citizens and not just serfs, and in which governments and not just bankers (like the Fuggers in the Spanish case) buy foreign bonds, pressure from international bondholders and pension funds might rise up and replace the IMF.

But it is unpredictable how this process might play out, and only time will tell.